A new debt workout mechanism: the state of the debate early 2017 part 1

Why a new mechanism is needed

Hvor veien går videre får du vite i del 2.

Between 1999 and 2005 substantial progress was achieved in terms of debt relief for poor developing countries. Through a combination of partial debt relief and strong economic growth, key indicators of indebtedness have been reduced considerably in some of the poorest and most heavily indebted countries (HIPCs). In a few non-HIPCs individual agreements on debt cancellation have also led to considerable improvements, including Iraq after the fall of Saddam Hussein and Nigeria in 2005.

During this process the international community has failed, however, to further develop any instrument for negotiating sovereign debt difficulties if and when they occur. The HIPC and MDRI relief schemes were deliberately designed and run as one-off exercises by one out of several classes of creditors, with others only reluctantly participating, if at all. Thus, a newly over-indebted developing country today will face the same problems, which countries faced with the outbreak of the debt crisis in 1982. The most important ones are those, which have caused the HIPC process to deliver substantial relief only after a protracted period of piecemeal and insufficient regulations between 1982 and 2005:

• First, there exists no mechanism to reduce a country’s exposure to all its creditors in a fair, orderly and pre-defined way. Instead each creditor group - bilateral official creditors, multilateral financial institutions, private banks and bondholders, have established separate fora for negotiating with an insolvent sovereign debtor, or none at all. Debt sustainability, however, cannot be defined with regard to individual creditor groups, but only with a view to the entire debt stock. The result of such fragmentation was that each creditor group tended to wait for concessions by the others, hoping that it will itself be spared from any concessions. Ultimately undeniable relief has thus been delayed and become much more costly than would otherwise have been unavoidable: socially and economically for the debtor, but financially also for the bona fide creditors.

• Secondly, these existing mechanisms have implied decision making by creditors. Against a fundamental principle in international jurisprudence creditors have thus become judges in their own cause. This was not only grossly unfair, but also extremely ineffective in terms of a quick and less costly solution to a debt crisis.

• Thirdly those decisions have always been made on the basis of expertise by the World Bank and the IMF, two institutions, which not only are controlled by the rich countries, which hold the majority of the voting power but moreover are creditors to almost any indebted sovereign themselves. Their expertise in one way or another therefore has an immediate influence on the validity of their own claims on the sovereign. It is hard to imagine any more blatant conflict of interest. The result have been debt sustainability analyses made in Washington which were way off the reality of the debtor country in question, but only served to align the "needed" debt relief, with what creditors at a given moment in time were prepared to provide.

A long series of alternative proposals

From the 1980s onward responses to the "Third World Debt Crisis" have mostly focussed on the need for an immediate debt cancellation. However, academics, NGOs, UN organisations and at one occasion even the IMF have been looking beyond immediate relief and into the need for a more structural solution, which would change the landscape for any sovereign who would run into payment problems in the future - rather than only the one(s) immediately or most acutely affected. The most important proposals for a broader and structural reform were:

• The proposal to internationalize the chapter 9 of the US Insolvency code, which organizes the insolvency of "municipalities", i.e. public bodies with governing powers, elaborated by Professor Kunibert Raffer of the University of Vienna. This proposal already overcame the counter-argument that private sector insolvency can not be applied in the sovereign sphere, because there was no way to respect the democratic substance of public entities. Chapter 9 does exactly this.

• The IMF's attempt to establish a "Sovereign Debt Restructuring Mechanism (SDRM)" between 2001 and 2003. That proposal went a long way in establishing a comprehensive process with the Fund's power as a guarantee that no creditor would escape a multilateral agreement. However, by installing itself more or less directly as the arbiter in the process, the Fund killed its own proposal: it failed to gain sufficient traction with international creditors and Fund member governments, who feared that the SDRM would constitute to much of an intervention into markets, which at that time were just recovering from the Asian crisis; but also from debtors in the global south and international civil society who were not prepared to accept an institution as arbiter, which at that time had a terrible record even as a provider of technical expertise because of its enormous bias towards creditors' interests.

• The proposal of a Fair and Transparent Arbitration Process (FTAP), developed by the global Jubilee movement. It largely built on the Raffer proposal, mentioned above, but included more options for decision making outside Raffer's arbitration proposal, in order to accommodate different situations, which in some circumstances f.i. could reach viable compromises between debtors and creditors through a less formal mediation or facilitation process.

• There were several variants of the FTAP, such as AFRODAD's "FTA" and its Latin American version TIADS (Tribunal Internacional de Arbitraje sobre Deuda Soberana), developed by Latin American Economists Alberto Acosta and Oscar Ugarteche. TIADS aims at establishing a decision-making body on sovereign debt at the UN or at the International Chamber of Commerce.

• The Dutch government developed a proposal for a sovereign debt tribunal, established at the International Court of Arbitration in the Hague. Unfortunately this proposal, which was well received in the global law community, was abandoned, when national elections replaced the labour party government with a centre-right administration.

These proposals have in one way or another dominated the debate on new and more efficient debt relief mechanisms before 2008. However, reform demands were an uphill battle. Between the demise of the SDRM and the global financial crisis in 2008, creditors turned euphoric about sovereign debt: The mood at that time was indeed that debt problems had been overcome for good through the HIPC initiative for the poorest countries and through the Brady plan implemented after 1989 for countries with market access and exposure to private banks.

The Lehman bankruptcy, the subsequent meltdown of interbank lending and the following sovereign over-indebtedness of countries in the European periphery provided all those dreams with a hard landing.

The next debt crisis

The combination of extremely low global interest rates and falling commodity prices presently provides the stage for a next sovereign debt crisis which will be very similar to the one we saw in the early 1980s - and with the same results: More and more countries resort to international (and domestic) borrowing in order to fill the gaps caused by their falling (commodity export) revenues. Investors in the global north who are hardly able to find rewarding investment opportunities in their home countries outside sectors like the housing bubble, find loan making to sovereigns in the global south at interest rates above 5% for their bonds and at occasions as much as 15% for bonds in hard currencies most attractive. Consequently debt indicators are already skyrocketing: Out of 36 HIPCs which have been relieved from their old debt through the initiative, the IMF finds already one in debt distress, 8 with a high and 22 with a moderate risk of debt distress.[1] "Moderate" in this case means that under the Fund's normally optimistic baseline scenario no critical debt threshold will be breached, while under any of the Funds routine stress tests, this happens to at least one of them. A "high risk" means that even under the baseline scenario, which the IMF considers to be the most likely development in the foreseeable future, debt indicators will breach their respective sustainability thresholds. erlassjahr.de's annual debt monitor based on end-2015 data finds 115 low and middle income countries with at least one (mostly several) indicators in a critical stage: a rise from 88 countries end-2013 to 108 for end-2014.

When it comes to solving such crises, restructuring debt has become more complicated. The ranges of creditors and of lending instruments, which these creditors use, have considerably broadened up through the past years. Some emerging economies in Eastern Europe or the Global South have themselves become lenders to foreign sovereigns and so have private investment funds and domestic lenders. New debt can come in the form of new types of bonds, through traditional syndicated loans, through a new wave of aggressive marketing by Export Credit Agencies, or the greatly expanded multilateral post-crisis-lending.

Excessive new borrowing cannot be ruled out.The International Financial Institutions (IFIs) have tried to control this new borrowing with the help of the World Bank’s Debt Sustainability Framework (DSF). The framework threatens to punish borrowers with a loss of access to highly concessional IDA financing, if they borrow beyond sustainability limits as defined by the Bank. This approach unilaterally exerts pressure on the borrower, without providing much of an incentive for the creditor to forego an investment opportunity. Consequently - and also due to the many waivers granted by the International Financial Institutions, the framework has had little success in limiting the taking of new loans.

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[1] IMF: List of LIC DSAs for PRGT eligible countries; as of Sept. 1st 2016.

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